Archive for June, 2013

In what seems to be one of the most prevalent campaign pitches in each election of recent memory, the reformation of the U.S. tax code has once again begun (continued) in Washington. In the most recent events, a Congressional discussion occurred regarding U.S multinationals shifting their offshore profits and tax avoidance. This discussion involved Apple’s CEO, Tim Cook, who pleaded for simplification, amongst other things. Tax code ‘simplification’ has been long claimed as the ultimate goal, all while on-going legislation and court decisions continue to work in a contradictory manner. In a surprising Congressional twist, it appears that both Democrats and Republicans agree on the idea that reform is necessary, however the union of parties stops there. Political philosophies have remained constant on the issue, and as the fiscal cliff debacle of early 2013 has shown, negotiations have proved fruitless in bringing Congress together.

In the belief that an informed electorate is the most effective way of instituting change, an analysis of the current facts behind the U.S. Corporate Tax structure pertinent to these hearings will be presented, along with a closer look at Tim Cook’s Congressional appearance and his push for change.

The Facts:

Statutory Rate

The United States currently holds the title of highest corporate statutory tax rate in the world. The federal rate currently sits at 35%, while the combined rate between federal and state is 39.2%. This title had previously been held by Japan, who lowered their corporate tax rate in 2012 in an attempt to help grow their economy.

The graph above, provided by Taxfoundation.org, shows the trend of corporate tax rates throughout the Organization for Economic Co-operation and Development, a group of 34 countries with market economies. The facts show that while on average, corporate tax rates have continued to drop since the early 2000s, the United States rate has stayed primarily the same.

Worldwide Taxation

Worldwide Taxation is a concept that is very important to the purpose of the Congressional panel. Contrary to a territorial system of taxation, where a company is only taxed on earnings that come from within a country, a worldwide system of taxation taxes a company based on its worldwide earnings. The United States operates under the latter.

Currently, the United States taxes earnings on foreign income only when it is repatriated back to the United States. When a company brings back earnings, it is taxed at the effective rate of 35% less a credit for foreign taxes paid on that income. Some argue that this incentivizes companies to keep earnings overseas, and to an extent they have a point. According to a study by J.P. Morgan in 2012, 1,113 U.S multinationals have more than $1.7 trillion dollars of undistributed foreign earnings. Companies who choose to keep their earnings overseas and invest them, however, still will face immediate taxation on any passive investment earnings (interest, dividends, etc.), as these investment earnings are classified as ‘Subpart F’ income (a complex portion of the Internal Revenue Code , a discussion of which is too lengthy to be presented here).

Tax Repatriation Holidays

The U.S. Government has, both in 2004 and 2009, initiated tax-repatriation holidays in an attempt to encourage companies to bring back funds to either invest in the U.S economy or distribute to their shareholders (in which case they would realize taxes on dividends at the individual level). During these periods, companies were able to repatriate their foreign earnings at a rate much lower than the statutory 35%. By implementing a tax repatriation holiday, the Government hoped that these companies would bring back earnings to create new jobs and invest in the U.S. Results of the two previous programs in these areas are mixed and prove hard to isolate. One thing is clear though, if a working assumption that these earnings will eventually be repatriated back to the United States is made, then a program like this will cost the U.S. Government a large amount of money. This can be quantified as the difference between the statutory rate and the temporary repatriation rate, or about 30% for the 2009 program.

The fact that the Government has now set the precedent of a tax-repatriation holiday has become an issue of concern, as multinationals can work under the assumption that the U.S will initiate another similar policy at some point, and wait to repatriate their earnings until that time, saving large amounts of tax liability on their foreign earnings.

Effective Rates

While it is clear that the United States imposes the highest corporate statutory rates in the world, it is more important to look at effective rates when evaluating the U.S. tax position amongst other countries. The effective rate evaluates what companies actually pay after all deductions, credits and such have been taken into consideration. According to a PricewaterhouseCoopers and Business Roundtable joint study, between the years 2006 and 2009, the United States ranks sixth in the world in effective tax rate, at 27.7%. As expected by their previously higher statutory rate, Japan led the field of 59 countries observed with an effective rate of 38.8%, followed by Morocco, Italy, Indonesia and Germany.

While pundits often refer to individual companies as having low effective tax rates, it is important to take into consideration the facts of the study—nearly 500 U.S. companies were studied, and 27.7% is an average of these companies effective tax rates over the four year period.

During a Congressional Panel of the Investigation Subcommittee of the Senate Homeland Security and Governmental Affairs Committee on May 21, 2013, Apple’s CEO Tim Cook was present for a discussion on offshore profit shifting and tax avoidance, particularly in reference to the accusation that Apple was guilty of these actions. This investigation has also looked into companies like Microsoft, Cisco and Hewlett-Packard, who have been accused of doing the same.

The Subcommittee accused Apple of avoiding taxes on nearly $44 billion by sheltering it overseas. Largely due to a number of legal accounting structures, Apple holds nearly $102 of its $145 billion in cash reserves overseas. Senator Carl Levin (D-MI) has made the claim that this has allowed Apple to avoid nine billion dollars in U.S. taxes by taking advantage of offshore loopholes and funneling much of its cash and foreign profits to Ireland, where they have a preferential 2% tax rate. Additionally, Senator John McCain (R-AZ) was quoted as saying, “It is unacceptable that corporations like Apple are able to exploit tax loopholes to avoid paying billions in taxes,” claiming that Apple, who paid over six billion in taxes in 2012, was “the most egregious offender.”

Coming to the defense of his company, Tim Cook emphatically responded by citing that Apple’s corporate structure has remained the same since 1980, and that they have structured their system in a way to maximize their expertise and corporate operations. In relation to the accusations, the CEO stated, “I can tell you unequivocally that Apple does not funnel its domestic profits overseas. We don’t do that. We pay taxes on all the products we sell in the U.S., and we pay every dollar that we owe.” Implications of Cook’s statements suggest that he believes the problem is not with Apple’s compliance, but with the tax code itself.

Tim Cook went on to qualify these implications by giving the Congressional panel recommendations for tax code reform, citing that Apple desires simple operations. A simple tax code would also seem to follow the corporate operational strategy, as he called for the elimination of all corporate tax expenditures, lowering of the corporate income tax rates, and implementation of a reasonable tax on repatriated earnings. The final comment was of particular interest, as Cook cited that a reasonable repatriation rate would be in single digits, similar to the rates in the periods of the tax-repatriation holiday. This would basically mean a permanent tax holiday for foreign earnings. Visible through these suggestions, “Taxcode Nano,” as dubbed by John Stewart (see attached video for comic relief), truly sings of simplicity.

Conclusions

While Cook’s suggestions echo the attitude of many U.S multinationals, his challenge to Congress is no easy task. There are many competing factors in tax reform, but without some sort of cohesive objective between both sides of the aisle, nothing will be accomplished. Do companies like Apple have a duty to pay taxes on their U.S. earnings? Absolutely. Do companies have a duty to bring back their foreign earnings and be taxed on them in the U.S. immediately? The law says no, but Congress says they should. There is, however, a different side to this debate that taxes do not take into consideration, the shareholders.

Companies have a fiduciary responsibility to maximize value creation. Value creation in the eyes of the shareholder is typically viewed in two ways: through dividends, or through share price appreciation. Both of these factors are benefited by lower taxes. In the former, companies have come to expect that eventually, the government will roll out another tax-repatriation holiday (based on previous precedent), and they will be able to bring back these amounts at a single digit tax rate, rather than the statutory tax rate of 35%, leaving more cash available for distribution to shareholders. Likewise for market price per share, lower income tax expenses will lead to higher assets and higher net income, leading to a more favorable valuation in the marketplace.

Similar to an elected official owing a duty to his/her constituents, companies owe a duty to their shareholders. If these companies are able to hold to this duty, all while complying with tax compliance laws, then they are simply managing competing objectives well. While the argument can be made that special interests had their hand in creating the tax legislation, ultimate decision to the letter of the law lies with Congress and our courts. If Congress and their constituents are unhappy with the legal actions of taxpayers, it is ultimately Congress’ responsibility to make a change. Tim Cook expressed the attitude that corporations, too, are on board with tax reform, so the ball is in the court of Congress to change the system, and corporations should not be blamed for taking advantage of legal methods to reduce their tax liability.

Link to John Stewart analysis of Tim Cook’s appearance in front of Congressional Panel:

Starting in 2009, the U.S. government began an outward push to punish those taxpayers who hold foreign bank accounts and have previously neglected to report them on the informational Foreign Bank Account Report. While multiple amnesty programs have been released that offer civil penalties in turn for immunity from criminal prosecution, these programs are contingent upon acceptance into the program by the Internal Revenue Service (IRS) and carry hefty fines.

Since 2009, U.S. officials have charged at least 71 taxpayers with crimes related to hiding offshore accounts. Compared with other criminal tax cases, judges have consistently delivered rulings that err on the lenient side in terms of prison time. For comparison purposes, the average sentence in a tax shelter case over the past three years has carried prison time of 30 months. From the start of the government’s push to prosecute offshore account holders, the average sentence handed down in these types of cases has been less than half that.

What causes the discrepancy in sentencing between one form of criminal tax behavior and another? Experts point to many factors. For one, the Offshore Voluntary Disclosure Initiative amnesty programs have been successful. These programs have admitted more than 39,000 taxpayers, raising more than $5.5 billion dollars. Cooperation by defendants has also contributed toward the lower than recommended sentencing. Cooperation by the defendants is extremely valuable to investigators, as they are able to use information from defendants to seek out banks and other account holders who have failed to report. On the justice side of the decision, some judges have found it unfair to jail defendants when many of their circumstances match those who settle their case civilly upon acceptance into the OVDI program. Finally, judges take into consideration sentencing in similar hearings when deciding upon the case. Since the precedent of lenient incarceration rulings has been set, judges have been more likely to continue the trend.

While lower than recommended sentences have, on average, been handed down in offshore account cases, playing roulette with the IRS and the justice system is never recommended, and taxpayers should still make necessary strides to become compliant.

The items in this blog are informational only and are not meant as professional advice. Consult with your tax advisor to determine how any item applies to your situation. Kimberlee Phelan writes Where In the World, and any opinions expressed or implied are not necessarily shared by anyone else at WithumSmith+Brown.

Author

Kimberlee S. Phelan, CPA, MBA, specializes in international tax, concentrating her efforts on special projects involving corporate tax research and planning, as well as inbound and outbound international structuring for corporations and individuals. She is actively involved in Withum’s international affiliation of firms, HLB International, serving as the co-chair of the HLB North America Tax Services Group as well as co-chair of the HLB International Tax Committee.

Having travelled to over 40 countries, Kimberlee will write about her experiences in this blog, highlighting interesting discoveries, tax and accounting law changes, as well as important business and etiquette tips.